A bipartisan economic booster shot

Last Friday the President spoke about the need for additional Congressional action on the economy. Outsiders are referring to this as fiscal stimulus. We’ve been calling it a growth package.

There’s a lot to say, so I’m going to break this up into three big parts.

what the President proposed;

why the President proposed it; and

today’s bipartisan agreement, and why we support it.

1. What the President proposed last Friday

Here are the President’s remarks from last Friday. They’re short and well worth reading, and they contain a lot of substantive content.

To put it simply, the President proposed that Congress pull the fiscal policy lever to increase economic growth (GDP) this year. You’ll remember (or not) from your macroeconomics course that there are two basic governmental tools for addressing the short-term economic picture. The Federal Reserve has a monetary policy lever, and the Congress has a fiscal policy lever. The Federal Open Market Committee pulled their lever on Tuesday, by cutting both the federal funds rate and the discount rate by 0.75 percentage points (experts say “75 basis points”). We studiously refrain from commenting on the Fed and its tools.

Last Friday the President described the shape of an effective growth proposal. He did this instead of laying out a detailed proposal, in part at the request of Congressional leaders on both sides of the aisle, to allow them some flexibility in their negotiations. It appears to have worked.

To actually increase GDP in the near term, an effective growth package must be:

Bigenough to move the needle on a $14.5 trillion economy. The President proposed a package that’s 1% of GDP, or about 145 billion dollars in 2008. That’s 50% — 100% bigger than what Congress has been discussing for the past two weeks.

Immediate. This means (i) Congress should pass legislation immediately. (ii) Policies with immediate macro effects are better than those with lagged effects.

Based on tax relief. Individuals, families, and businesses will react quickly (and more effectively) if they are deciding how to spend more of their own money. Government bureaucracies react slowly.

Broad-based. Many were emphasizing “targeted.” In contrast, we think policies should be neutral and distort decisions as little as possible. We have a macroeconomic focus on sectors of the economy, like increasing consumption and business investment. This is in contrast to those who implicitly have a microeconomic focus on particular constituencies in American society. There’s also a difference in philosophical approach, between helping the American economy as a whole, to benefit everyone, and helping those parts/members of the American economy that someone deems to be “most in need of assistance.” (In retrospect, some were also using “targeted” to refer to the income distribution of tax relief. In this respect, we think that the compromise announced today addresses their concerns.)

And temporary. As a general matter, we prefer long-term policy changes, especially on the tax side. In this case, our policy focus is insuring against drops in GDP growth without significantly raising the national debt. That necessitates short-term and temporary policy changes. (It also dramatically increases the chances of a bipartisan legislative success.)

The President also described a couple of things that move in the wrong direction. To be effective, a growth package must not:

Raise taxes.

Waste money on federal spending without an immediate positive effect on GDP growth.

In addition to these principals, the President suggested that a growth package should try to increase consumption (70% of our economy) and business investment (11%). The President said that to be effective, a growth package must:

Include tax incentives for American businesses to invest (especially small businesses).

Include “direct and rapid income tax relief” to increase consumer spending.

You don’t get a booster shot when you’re sick. You get it when you’re well, but you’re concerned you might get sick. It’s a preventive measure to reduce the chance that you get sick.

Let’s start with three simple but critically important facts:

The single most important indicator of a healthy economy is how many people are working. The unemployment rate is now 5.0%. While that’s up quite a bit from 4.7% in the prior month, 5.0% unemployment is still a very good number. Lots of Americans are working, and that’s good. Today’s unemployment rate is below where it was (on average) in each of the last three decades.

The U.S. economy is growing, albeit slowly. We had a strong 3rd quarter last year (GDP +4.9%). But private sector projections for both Q4 of last year and Q1 of this year fluctuate around +1% (with a big error margin). That’s a significant slowdown, and it’s slower than we would like. (Silly but important reminder: “slowdown” does not equal “recession.” Slowdown means slow growth. Recession means negative growth. Rule of thumb: a “recession” is two successive quarters of negative GDP growth. And for the technicians, yes, the NBER’s definition is actually more complex than this.)

The President’s economic advisors and most private sector forecasts expect the economy to continue to grow this year, albeit slowly. The most likely scenario is slow GDP growth through the first half of 2008. Most also predict that growth will accelerate somewhat in the second half of the year.

It’s easy to miss these three facts, because much of the press coverage has glossed over them and instead covered the possibility of worse economic scenarios.

Future downside risks provoke economists inside and outside the Administration to recommend an economic booster shot. Most economists raise housing problems and financial markets issues as the greatest near-term threats to continued economic growth. Many also point to the economic drag of expensive oil.

While much of the policy and legislative discussion in the Fall was about housing finance (mortgages), the principal macroeconomic issue is the actual houses themselves. Fast-rising house prices created an incentive for builders to keep putting up new houses beginning in 2003, and inventories built up. When a manufacturer has lots of products in its inventory, it slows down the manufacture of new goods. The same has happened, quite dramatically, in the housing sector. Builders aren’t building because there’s a big supply of unsold houses on the market (with significant regional differences).

As long as housing inventories remain high:

since supply exceeds demand, prices of new and existing houses will decline (by how much is highly uncertain); and

builders won’t build many new houses; so

the residential construction component of GDP will shrink; and therefore

a shrinking housing sector will cause slower overall economic growth.

These adjustments in the housing sector will take some time. We need to make sure that policy in Washington doesn’t make this problem worse. We are also watching carefully to see whether problems in the housing sector bleed over into consumer spending. This could happen in one of two ways:

If your home is worth less, you have less overall wealth. The evidence shows that you then spend less (maybe 1 or 2% of the decline in your wealth). This is the “wealth effect.”

If your home is worth less, you might be less confidence about the economy as a whole, and this might cause you to spend less.

It’s important to understand that the President’s proposal from last Friday was about the U.S. economy as a whole, and his proposal focused on consumer spending (70% of the economy) and business investment (11%). The housing sector needs to adjust, and we can have a greater effect with fiscal policy on consumption and business investment, through the policy direction outlined by the President last Friday.

To summarize:

Our economy is growing, albeit slowly.

We think the economy will continue to grow, albeit slowly. We are not predicting a downturn.

There are risks to that growth projection, especially from housing, the financial markets, and high oil prices.

The President proposed that Congress quickly enact legislation to address these risks.

3. Today’s bipartisan agreement, and why we support it.

A short while ago House Speaker Nancy Pelosi (D-CA), House Republican Leader John Boehner (R-OH), and Treasury Secretary Hank Paulson announced their agreement on a growth package. The Speaker said she intends rapid legislative action in the House.

Here’s a useful summary, followed by our evaluation of how this agreement fits with the principles the President offered last Friday.

House Bipartisan Leadership Growth Plan Agreement

What it does:

Part I: Personal Tax Relief ($103 B)

Cut the 10% tax rate in 2008 to 0% for the first $6,000 (individuals)/$12,000 (couples) of taxable income

Maximum rebate: $600 (individuals)/$1200 (couples)

Minimum (refundable) rebate check: $300 (individuals)/$600 (couples)

Eligible if earned income > $3,000 (subject to income limits below)

Rebate phases up from $300 to $600 for those with taxable incomes ranging from $3,000 to $6,000

Additional refundable tax credit of $300 per child for those who otherwise receive a rebate

Full rebates/credits are available to those with adjusted gross income (AGI) < $75 K (individuals)/$150 K (couples)

Increased expensing for small business (Section 179 limit raised from $125 K to $250K)

The agreement would also increase the conforming loan limits for Freddie Mac, Fannie Mae, and the Federal Housing Administration.

Why it is good:

Effective: The package addresses the two major components identified by the President as essential to promoting near-term growth: boosting consumer spending and business investment.

Timely: The personal tax relief will begin to stimulate consumer spending and additional economic growth within about 60 days of enactment. The business incentives will spur investment throughout 2008.

Temporary: The package will provide immediate relief to the economy without turning away from policies to promote long-term growth and to balance the Federal budget.

Rewards Work: Individuals must have earned income to receive the $300 rebate check.

Broad-based: Rebates will reach 117 million households.

Neutral: The package allows individuals and businesses to decide how best to use the relief provided.

What it does not do:

The package does not raise taxes.

The package is not a collection of spending programs; it does not include any government outlays beyond the minimum rebate check and refundable child tax credit.

The package does not contain wasteful provisions that would spend money slowly, failing to meet near-term economic objectives.

The package does not contain lender bailout provisions that would interfere with ongoing and necessary corrections in the housing sector.

I want to return to the criteria the President laid out last Friday, to see how the bipartisan agreement matches up.

Big The President proposed 1% of GDP, or about $145 B. This package is about $153 B.

Immediate We got a bipartisan agreement in the House even faster than we expected, thanks to the excellent work and leadership of Secretary Paulson, Speaker Pelosi, and Leader Boehner. We hope for quick legislative action, and similar bipartisan support in the Senate. TBDWe anticipate advance refund checks could start being delivered about 60 days after the President signs the bill into law. TBD

Based on tax relief The entire package is done through tax relief, excepting one mortgage-related provision (that does not affect spending). The refundable aspects of the tax relief technically count as spending. But the other spending items (which we opposed) are all excluded from this agreement.

Broad-based It is very important to us that the government not pick particular constituencies as more “deserving” of tax relief. The agreement largely meets that test.

You can see why the President is strongly supporting this bipartisan agreement. He said a short while ago, “Because the country needs this boost to the economy now, I urge the House, and the Senate, to enact this economic growth agreement into law as soon as possible.” We have an opportunity to come together, and take the swift, decisive action our economy urgently needs.